Jonathan Davis: Don't expect tomorrow's profits served on a plate

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The Independent Online
What do we know about bear markets? Most of the time they tend to be relatively short and painful, a matter of months rather than years. They are usually (but not invariably) linked to some impending change for the worse in the economic environment. As the gloom intensifies, they tend to bounce a lot of weak holders of shares out of the market, while those who remain are eventually rewarded by a strong recovery. In fact, a large part of the excess returns that give shares their long-term premium rating as investments are typically packed into the periods immediately before and after bear markets

What do we know about bear markets? Most of the time they tend to be relatively short and painful, a matter of months rather than years. They are usually (but not invariably) linked to some impending change for the worse in the economic environment. As the gloom intensifies, they tend to bounce a lot of weak holders of shares out of the market, while those who remain are eventually rewarded by a strong recovery. In fact, a large part of the excess returns that give shares their long-term premium rating as investments are typically packed into the periods immediately before and after bear markets.

When talking about bull and bear markets, one has to be careful to distinguish between movements in short-term market trends and deeper, longer-run secular forces that shape the overall valuation of all types of investment class. The 1987 market crash is the best example of a pure market correction, in which investors' excessively optimistic expectations were abruptly and brutally brought to earth, without any great lasting consequences.

The best recent example of a long-term secular trend is the global fall in interest rates and inflation expectations that can be dated from the early Eighties, when Paul Volcker, then chairman of the Federal Reserve, launched a far-sighted assault on inflation. As interest rates have fallen around the world, investors have become progressively more confident that inflation has indeed been slain, with the result that the prices of most types of asset have been bid up to ever higher levels.

This is a good example of a secular bull market trend, where improving fundamentals ("good economic numbers") have been followed then matched by a ratcheting upwards in overall valuation levels.

There is a strong theoretical justification for the long secular improvement in share values we have witnessed. When interest rates fall from 10 per cent to 5 per cent, inflation halves to 2.5 per cent, and company earnings are rising ahead of inflation, it is logical that the value of shares in those companies should rise at a fair lick. The only snag is the real danger that investors can become over-confident and complacent about the future, so they bid up prices too far in anticipation of the good times lasting forever.

That this can happen is one of the lessons of the great tech stock boom of a year ago. While it was theoretically possible to justify technology companies being valued at 100 times forecast earnings, to do so you had to assume that their growth could continue to compound at the same rate for at least 10 years, a heroic assumption even for the best companies (such as Cisco), and downright impossible for most of the untried businesses that floated to the market in the wake of soaring tech stock prices.

As we are again clearly in bear market territory, the most important question is whether we are looking at a pure market correction, in which excessive expectations are being dashed, or a more fundamental secular change in the investing environment.

We could be looking at both, though if that is the case, by its nature it is unlikely we will see clearly what the secular change is until we are well into it (just as investors in the early Seventies were unable to see clearly how bad the inflationary crisis of the mid-Seventies was going to be). In the short term, it seems clear that the major visible economic risk is the slowdown in the US economy, which could easily tip over into recession, dragging the rest of us down with it. Longer term, the challenge for the US economy is to find a way of correcting the structural imbalances that have developed over the last decade (big current account deficit, low savings rate, high levels of indebtedness) without triggering a wave of panic selling by investors.

The simplest way to clear debt is to have a quick burst of inflation, which may be what we get, with or without the benign connivance of Alan Greenspan, once the US economy starts to pick up.

Nobody really knows how the real economy is going to develop. What we do know is that the valuation risk in the stock market, both in the US and in Europe, is still high. Even after the 20 per cent-plus correction we have seen in the US market, it still looks more than fully valued on most criteria, other than comparison with the golden 1995-2000 period. What this means is that the market is still vulnerable to a double whammy of deteriorating economic fundamentals (whether short term or secular we don't know) and a shift for the worse in valuation parameters.

In the table below, I reproduce in more detail the analysis by Professor David Wilkie I mentioned briefly a couple of weeks ago, which highlights how the components of equity market returns have changed over the past three decades. These figures are for the UK, though the numbers for the US and German stock markets do not look very different (for those who are interested, the full text of Professor Wilkie's paper can be found on his website www.inqa.com).

The key point to notice is how important changes in valuation, as measured by dividend yields (columns 1 and 2) and the effect of rerating on overall returns (the final column), have been in driving the market to its high a year ago. While the stock market gains of the 1980s can be largely attributed to improvements in fundamentals ­ witness the 5.3 per cent annual growth in real dividends ­ the similar-sized gains of the Nineties have largely been the result of investors rerating what shares have to offer. Dividends barely grew in real terms over the decade 1990-2000. And dividend cover, the extent to which dividends are covered by corporate earnings, has fallen to its lowest level since the early 1960s.

As an actuary, Professor Wilkie is not in the business of forecasting short-term returns, but he has done simulations to look at possible outcomes, based on a complex multi-factor model used by several invest- ment institutions for asset/liability calculations. The table shows the output for three possible sets of assumptions. One, scenario A, shows what would happen if the dividend yield change of the past 10 years were to reverse itself in the coming decade. This is a secular bear market story, with shares producing negative returns of 6 per cent compound per annum, not a pretty thought.

The other two scenarios show more moderate outcomes, with flat or mildly negative returns in the next 10 years followed by a return to positive market growth in the following decade. The point Professor Wilkie makes is not that this is what will happen, but that you have to make strong assumptions to justify the market retaining the kind of growth rates most stockbrokers even now will try to persuade you to believe.

In particular, he says, you have to project either a return to high inflation, strong growth in real dividends or a further rerating of shares (ie still lower dividend yields) to justify thinking that shares can match the returns of the past two decades.

His conclusion is: "It seems to me more likely than not than none of these will happen; I therefore see the prospects for shares in the next few years as poor. My own estimate would be that cash might well give the best returns."

This kind of analysis would have turned you away from shares well before the market reached its peak, but that is just another way of saying that those with the highest equity market returns are those who are willing to sail as close to the market peaks as they dare, hoping to get out in time before reality breaks back in. It does not mean there will not be good moneymaking opportunities in the equity market ­ history suggests there will be plenty ­ but they probably won't come served on a plate as they have been in the past few years.

¿ davisbiz@aol.com

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